John W. Diamond, “The House’s Tax Relief Plan Is a Lesson in Poorly Designed Fiscal Policy” (Houston: Rice University's Baker Institute for Public Policy, March 8, 2024).
The House recently passed the Tax Relief for American Families and Workers Act (TRAFWA) of 2024 with significant bipartisan support. The bill, which has so far stalled in the Senate, aims to provide tax relief to businesses and families with children in a fiscally responsible manner. Unfortunately, if the bill succeeds, that would not be the case. Instead, it would deliver more reckless tax giveaways over the next two years while further delaying a real effort to deal with the consequences of poor fiscal policy. This must stop.
TRAFWA would indeed cut taxes for some businesses and families with children. But these cuts would be temporary and retroactive — two warning signs of poor, gimmicky policy design. This approach highlights several problems with current tax policy, such as the propensity for Congress to pass temporary tax provisions, spend through the tax code, and run large annual deficits. At a time when inflation is a lingering concern and deficits are ballooning, this legislation would increase near-term fiscal stimulus — and require higher taxes in the long term.
TRAFWA would reduce taxes for businesses by allowing immediate write-offs for research and development, instead of spreading the deductions over five years. It would reduce the limitation on interest expense deductions, allowing 100% bonus depreciation, and increase the expensing of short-lived investments.
Several of the provisions aimed at businesses would indeed increase economic growth by encouraging investment and innovation. But giving businesses tax breaks for past investments and research expenditures does not affect investment levels. They are nothing more than a government handout to businesses. Further, the additional debt related to the cost of the tax cuts would crowd out private capital and ultimately reduce growth. Note that even though this bill is revenue-neutral, the other option was to reduce the deficit instead of financing a government handout. While extending investment incentives is a good idea in general, this bill provides an example of how not to design such policies.
TRAFWA would also increase the child tax credit for families with children by making several changes to current law; these would include increasing the maximum refundable credit, adjusting maximum credit values for the number of children, and indexing to inflation the limit on the amount that is refundable. These policies would provide a financial benefit to low-income families with children. Nevertheless, its overall impact on reducing the adverse effects of poverty would be limited, as about one-third of the benefits accrue to households in the top three income quintiles. Policymakers should target help to those most in need and avoid fiscally irresponsible policies that are not well targeted. In addition, evidence shows that taxpayers tend to bunch at certain points in the tax code, such as the one created by the child tax credit. Thus, small changes in after-tax income can move large numbers of taxpayers across the poverty threshold. The positive impacts of such changes are limited, especially considering that impacted families are likely to share small increases in additional resources. Furthermore, the policy could reduce economic growth if it leads taxpayers to work less to qualify for tax refunds.
Another issue with TRAFWA is the timing of the deficits it creates. In particular, the bill would increase deficits by roughly $150 billion in the first two years. This would add counterproductive fiscal stimulus to the economy. With the Fed battling persistent inflation, the additional fiscal stimulus would stimulate the economy at the wrong time. Suppose the Fed responds by holding the federal funds rate higher for longer or increasing the rate to offset fiscal stimulus. In that case, the economy would likely slow down. Given that excess fiscal stimulus played a role in creating the current inflationary environment, it is fiscally irresponsible for Congress to add more short-term stimulus to the economy.
Amid the COVID-19 pandemic, Congress passed the employee retention credit (ERC) as part of the $2.2 trillion Coronavirus Aid, Relief, and Economic Security Act of 2020. The Joint Committee on Taxation initially estimated that the ERC would cost $54 billion. The Consolidated Appropriations Act of 2021 and the American Rescue Plan Act of 2021 extended and expanded the ERC, which added about $20 billion in estimated revenue losses. The Infrastructure Investment and Jobs Act of 2021 restricted the use of the ERC by certain employers, which raised roughly $8 billion in revenue. According to official estimates, the ERC was projected to reduce revenues by approximately $68 billion between March 2020 and the end of fiscal year 2022. The initial projections assumed the ERC would not reduce federal revenues in 2023. The Congressional Budget Office (CBO) projects that the ERC increased the deficit by about $120 billion in 2023, in addition to its impacts from 2020 to 2022.
TRAWFA raises revenue by disallowing claims for the employee retention credit (ERC) after January 31, 2024. As noted, the bill is revenue-neutral, according to estimates provided by the Joint Committee on Taxation. Using this provision as a fiscal offset is disconcerting for several reasons:
In testimony before the House Ways and Means Committee, IRS Commissioner Daniel Werfel stated that the “IRS has been flooded with ERC claims, and we are concerned that many of these claims are not being filed by businesses that qualify.” While the ERC should end as early as possible, the savings must not fund temporary government handouts. Instead, Congress must exercise more fiscal discipline. If the proposed policies are genuinely desirable, they should be part of a well-designed fiscal reform.
Since much of the individual tax code sunsets at the end of 2025, tax reform will be a significant issue in the next Congress. The cost of extending the provisions set to expire is estimated to be about $3.4 trillion, but this cost increases substantially if the provisions above are extended beyond 2025. Policymakers must find the will to practice fiscal discipline. They should start by rejecting the urge to increase government handouts and instead focus on fiscally responsible tax and spending reform.
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